ROTH In-Plan Conversions for Military Service Members

However, converting money to a Roth TSP requires careful consideration, and there are several aspects of Roth in-plan conversions you should know about.

Below are the key factors to make the decision easier, including eligibility, rules, pros and cons, and the risks associated with converting your traditional TSP to a Roth.

What is a Roth In-Plan Conversion?

The short answer is: move or convert money from your traditional (pre-tax) balance to Roth (after-tax) balance within your TSP. This allows you to pay taxes now and enjoy tax-free growth and withdrawals in retirement.

You don’t need a Roth account at this time. Your first conversion will create one.

Who is eligible?

You may be eligible if you are a current or former military member or a spouse who has inherited a TSP account. You must have at least $1,000 in vested funds, and each conversion request must be at least $500 (since you must leave a $500 hold on the non-Roth account).

What part of my traditional vested balance can I convert?

You can keep these eligible sources hidden:

• Traditional payroll contributions (taxable and tax exempt)
• Contributions corresponding to agencies
• Automatic contributions from the agency (1%)
• Rollover Contributions

Here is an example of balances and amounts eligible for conversion to a Roth:

Remark: This example reflects the required withholding amounts.

What are the rules and things to consider before deciding to switch to a Roth TSP?

• You may convert pre-tax deferrals, rollover funds, and earnings within your plan.
• Your conversion must be at least $500, and you must maintain at least $500 in each non-Roth account for retained funds.
• You can make up to 26 conversions per calendar year for each TSP account you have.
• You must make all required minimum distributions (RMDs) before conversion.
• Investments in investment funds cannot be converted directly. You must first sell them and transfer them to your traditional TSP account.
• The amount converted from pre-tax to Roth is a taxable event and is added to your gross income for the year and taxed at your regular rate.
• Taxes are not automatically withheld from the conversion, so you must pay them. You must also use personal funds (not the converted amount or funds in your TSP) to pay the taxes due on the conversion.
• The five-year rule applies to every conversion. If you withdraw converted funds and/or earnings before the five-year clock expires and before you turn 59 ½, you may be subject to a 10% penalty.

What is the five-year rule?

After you make a conversion, two five-year rules apply to withdrawals:

The first rule applies to the income into your Roth TSP, and determine whether you pay taxes on that income. You will not be taxed on this qualified income if you meet both of the following IRS requirements:

• Five years have passed since January 1 of the calendar year in which you made your first Roth contribution, or the first conversion into the plan if the conversion created your Roth balance.
• You are 59 ½ or permanently disabled (you must justify this on your tax return).

The second rule applies to the converted funds from your traditional TSP, and determines whether you will be charged a 10% early withdrawal penalty. Each conversion has its own five-year clock that starts on January 1 of the year of conversion. So if you withdraw converted money before the five-year clock expires, you will have to pay the 10% penalty, unless You:

• are 59 ½ or older, or
• be permanently and completely disabled, or
• dies (benefits go to the beneficiary), or
• meet another exception defined in the publication Tax rules on TSP payments

Please note that IRA exceptions (first home purchase, higher education expenses, unemployment insurance premiums) do not apply to the TSP.

For a tip: Make sure you keep careful records if you have multiple conversions.

What are the benefits of a Roth in-plan conversion?

The main benefits of a Roth in-plan conversion are tax-free growth and tax-free withdrawals once you qualify.

Here are some additional benefits that may make the decision to convert easier:

• There are no income restrictions like regular Roth IRA contributions.
• It is a hedge against future taxes, because you pay tax on the conversion now. This will help if your tax rate increases significantly in the future.
• No RMDs apply to the Roth portion of the converted funds (although an RMD may still be due for the current year).
• The conversion itself is not considered a withdrawal and thus is not subject to the 10% early withdrawal penalty.
• A Roth TSP provides a tax-free inheritance to pass on, especially if you move into a higher income and tax bracket later in life.
• It provides you with a diversified portfolio that gives you flexibility in your retirement planning.

What are the disadvantages and risks?

While there are many advantages to converting your traditional TSP to a Roth, there are also some disadvantages:

• You will be hit with an immediate tax bill on the converted funds, which will increase your marginal tax rate and possibly move you into a higher tax bracket. This increases the tax on all your income that year, including possible increases in your Medicare Part B and D premiums in retirement.
• Because you will need to use personal funds to pay your tax bill (you cannot use funds in your TSP account or converted funds), you need to make sure you have enough funds available to meet your tax obligations.
• If you need the money sooner than five years (the five-year rule), you may have to pay a 10% early withdrawal penalty.
• If you, your spouse, or your children are pursuing higher education, your higher income may make you ineligible for financial aid that year.

Can I undo a conversion?

Unfortunately you can’t. Once the transaction is processed, a Roth-in-plan conversion is permanent, irreversible, and cannot be recharacterized under current IRS rules. Because the conversion has so many consequences for your current and future income, savings and tax basis, it may be wise to first consult a tax advisor.

What should I do if I contributed tax-exempt income to my traditional TSP from wages earned in a combat zone?

If you contributed money from Tax Exclusion Wage for Combat Zones (CZTE) (after taxes), your conversion will be in the same proportion as your traditional TSP balance (before taxes). This is the pro-rata rule.

Here’s an example of how the Pro-Rata rule works:

For example, if you have $80,000 in your traditional TSP, and $20,000 of that is not taxable from your CZTE contributions, then 25% of the balance is not taxable. So if you convert $20,000 to your Roth account, $15,000 is taxable and $5,000 is non-taxable.

Remark: You can’t just convert your CZTE funds to your Roth; the pro-rata rule forces you to convert a mix.

Am I a good candidate for a Roth in-plan conversion?

Since you can make a Roth in-plan conversion at any time (whether working or retired), you need to decide if you are a good candidate and when is the best time to make the conversion.

The bottom line

Converting all or part of your traditional TSP balance to Roth status requires careful consideration and comes with benefits, drawbacks, and risks. So, you need to consider several factors, such as your current income level, tax-free income and current savings account, before taking the step. Based on your comfort level, consult a tax advisor to plan your conversion strategy to ensure your decision is the best one for you and your family.

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